Germany: German Dividend Planning Under Tax Reform

Originally published in March 2001

Germany's new tax rules generally enter into force on January 1, 2001. For German companies with a business year other than the calendar year, the provisions first apply for their business year ending in 2002. For the distributing German subsidiary, the old German distribution rate system applies with certain modifications for a transition period of 16 years. Further, the tax retained earnings basket system (vEK) will be continued in a modified form over the transition period.

For maximising the German tax benefits of distributions, it is important to differ between:

• old system dividends, where the rules of the old German imputation system still apply with certain modifications;
• transition period dividends; and
• new system dividends.

This differentiation is important to make maximum use of the opportunities offered by German tax reform and to avoid potential pitfalls. The comments below focus on the German tax planning for a cross-border dividend flow from a German subsidiary to a foreign corporate shareholder. The tax impact of German dividends in the jurisdiction of the foreign shareholder needs specific consideration. Due to the complexities of the German tax reform provisions, the German and foreign tax impact of any major dividend distribution by a German subsidiary needs detailed consideration and calculation of the related tax impact in each case.

Under the German tax system change, already a distribution from a direct German subsidiary to a foreign corporate shareholder gives rise to complex German tax issues. These considerations become even more complex, if there are dividends within a German group of companies. The comments below focus on a direct shareholding in a German subsidiary and do not discuss further tax aspects to be considered in the case of a German group of companies. For simplification withholding tax aspects, non-deductible solidarity surcharge and trade income tax are ignored below.

The German imputation system (whereby dividends carry a refundable tax credit for underlying German corporation profits tax) is abolished. Its final application will be to dividends for 2000 distributed in 2001. Therefore tax planning considerations for dividend distributions by German subsidiaries for 2000 in 2001 will focus on the following:

• maximising the distribution tax rebate;
• increasing the amount of distributable earnings in the 2000 commercial balance sheet;
• securing liquidity of the distributing German company by appropriate strategies;
• circumventing the reclassification trap of EK 45 tax retained earnings.

A loss of a potential distribution tax rebate could arise, where the German subsidiary has retained earnings taxed at the 45% corporation profits tax rate that applied before 1999 (EK 45). If not distributed in 2001 as a dividend for 2000, this EK 45 needs to be reclassified into positive EK 40 and negative EK 02. Such a reclassification of say 55 units of EK 45 (pre-tax 100 units less previous 45 corporation profits tax) could result in a significant tax disadvantage in specific tax equity situations, raising the effective distribution tax rate to 36% (instead of 30% standard rate). The following simplified chart illustrates the disadvantage (assuming existence of only EK 45).

The mandatory reclassification of previous EK 45 into EK 40 results in an effective distribution rate of (rounded) 36%. This disadvantage could be avoided by an EK 45 superdividend for 2000 distributed in 2001.

The tax rebate potential connected with a distribution of EK 40 earnings accumulated in 1999 and 2000 would generally be preserved under the transitional rules. However, there could be a significant disadvantage if the only other earnings basket is a basket of negative EK 02 (generally due to losses in previous years). The negative EK 02 amount will have to be offset against the positive EK 40 amount. This reduces the tax rebate on distribution on only the balance of EK 40 left after such offset. This pitfall could be avoided by an EK 40 superdividend for 2000 in 2001. This requires that the commercial balance sheet is financially restored and allows such dividend.

It is possible to avoid the above outlined reclassification traps by an EK 45 or EK 40 superdividend in 2001. However, such superdividend requires an adequate amount of distributable earnings shown in the commercial balance sheet as at December 31, 2000. There are various possibilities to establish such distributable earnings.

Such distributable earnings require, that the necessary amount is shown in the balance sheet as balance sheet profit. If the German subsidiary has the legal form of a GmbH, capital reserves or profit reserves built up in prior years could in principle be easily converted into distributable earnings. However, potential restrictions under German company law or requirements of the German subsidiary's statutes need to be reviewed prior to such dissolution of reserves for the benefit of increasing distributable earnings.

In the absence of such capital or profit reserves to be converted into distributable profits, other possibilities need to be looked into in the course of setting up the balance sheet. However, timing requirements may need to be observed for the respective appropriate transaction. Assuming, the German subsidiary had insufficient distributable earnings (e.g. due to losses incurred in 1999 or 2000), a cash contribution made prior to December 31, 2000 by a foreign corporate shareholder resulted in a non-taxable increase of the German subsidiary's distributable profit (so-called contribute/cash-out strategy).

Another possibility to increase distributable profits is a waiver of intercompany payables. Under certain circumstances, such waiver can be viewed as a non-taxable shareholder's contribution increasing the distributable profits. This requires, that such waiver is declared at latest as at December 31, 2000. In such case, the distributable earnings in the balance sheet as at December 31, 2000 would be increased accordingly (so-called waiver/cash-out strategy).

A further possibility exists, if the German subsidiary in turn owns majority shareholdings in other German companies which distribute their earnings by way of dividends. By accelerated recognition of such intergroup dividends as at December 31, 2000 the distributable profits at German parent company level would increase. The accelerated recognition of intergroup dividends already prior to actual distribution is bound to certain requirements (majority shareholding, distribution proposal, financial statements audited prior to the financial statements of German parent company etc.).

By appropriate transactions it is therefore possible to increase the distributable earnings per commercial balance sheet to secure a superdividend out of EK 45 or EK 40 earnings for 2000 in 2001.

A cash distribution of the above superdividend may be unwanted under cash-flow reasons. A further reason may be statutory equity requirements existing e.g. in the case of German subsidiary banking operations. In such a case, the superdividend will be resolved but not distributed in cash. Instead, it will be retained by the German subsidiary (so-called distribute/retain strategy). In order to benefit from the distribution tax rebate, however, additional criteria have to be met.

The above dividend distribution/retention strategy is not per se considered by the German Fiscal Authorities as an abuse. The distribution tax rebate will be granted, provided certain equity quality criteria are met. In essence, this requires, that the dividend amount based on proper dividend resolution is retained in the form of preferably capital reserves. The German fiscal courts have acknowledged, that profits distributed but not cashed out and retained as capital reserves qualify for the distribution tax rebate. This strategy requires an appropriate wording of the respective dividend resolution.